By Sean Goldsmith in the S&A Digest:

Last week, the Treasury Department admitted its Home Affordable Modification Program, its plan to help mortgage borrowers by reducing payments, was a flop. Around 70% of modifications, which use only interest-rate cuts and not principal reductions, default within 12 months. New York Times writer Gretchen Morgenson produced a great article explaining why (thanks to Whitney Tilson for sending this)...

First off, when calculating what it considers an affordable mortgage payment, the government doesn't account for the borrower's total debts – the first mortgage, second lien, credit-card debt, and auto debt. It only uses the first mortgage payment, insurance, and property taxes. So what looks like an affordable payment is still out of reach for most struggling borrowers. The article, quoting Lanie Goodman of Amherst Securities, says the government also fails to consider the borrower's equity – or negative equity in many cases – on the property. Goodman says negative equity, not unemployment, is the best predictor for defaults...

Ms. Goodman recently compared the experiences of prime mortgage borrowers living in areas with an 8 percent unemployment rate. Those with at least 20 percent equity in their properties were falling two payments behind for the first time at a rate of only 0.22 percent a month. But the same 60-day delinquency rate for those who owed at least 120 percent of the value of their homes was 1.46 percent a month.

Goodman says the government needs to address second liens and focus on principal reductions. But there's a huge reason second liens will likely still be ignored... The same banks the Treasury is urging to modify loans – Bank of America, Wells Fargo, JPMorgan, and Citigroup – hold $442 billion of second liens on their balance sheets. Writing those down would hurt the banks even more.

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